Encompassing a multitude
Emerging market debt (EMD) has long been a Cinderella asset class whose beauty is now finally being recognised by admirers. Historically seen as a high risk, high yielding asset class, 50% of the EMD indices are now investment grade. But “the most important secular change isn’t the increase in credit quality, it’s the changing structure of the investor base” according to Ashmore’s Jerome Booth. “Institutions are starting to realise that emerging market debt is a very important allocation strategically. They are starting to realise quite how big it is, at $4.3trn (E3.4trn)it is much bigger than say the FTSE 100.
“They are starting to realise that the market grew nearly 30% in size last year. This is a very fast growing, pretty large, pretty liquid market already and they are working out that there are different things they can do in emerging markets. They can have a very low volatility product, they can have it in all sorts of different formats to give them different risk/returns.”
While you can argue as to whether emerging market debt of all types should be regarded as a single asset class at all, what is certain is that it cannot be ignored.
A key theme in EMD today is the rise of local currency debt which is reflected in the recent launch of a specific index by JP Morgan, the Government Bond Index-Emerging Markets (GBI-EM) covering 19 countries within four regions - Latin America, Middle East/Africa, Emerging Asia and Developed Asia and includes liquid fixed-rate domestic currency government bonds accessible by foreign investors.
As Stone Harbor’s Tom Flanagan explains, “a trend we are seeing in the last few years is the market evolving with countries that have the ability to finance in local currency doing so”. EMD as an asset class has gone through a period of evolution since the early 1990s when many countries were in default on bank loans. These were securitised in the early 1990s with the Brady programme and more recently, countries have used global markets to refinance Brady debt. Panama for example, called back all of its remaining Brady bonds earlier this year. Accessing the global debt markets is seen as an important milestone in the economic development of emerging markets. The next stage is financing in local currency and developing a local credit curve. Flanagan sees the most prominent developments in Mexico and Russia “whose economic ratios tend to be better than many western countries, but because of the volatility over the last few years, have faced scepticism from investors.”
He adds that Mexico, an investment grade credit with a BBB “now has a 20-year Peso bond and has announced that they will do a 30-year peso bond. Aberdeen’s Brett Diment says: “Brazil’s yield curve goes out 30 years although liquidity is only out to seven or eight years and Turkey goes out to four years. Even though inflation has come down in Brazil, Brazilians are so used to high inflation that they keep low cash balances.
When you have a period of very high inflation it takes a long time for inflationary expectations to come down, but that gives a good opportunity to foreign investors to come in and buy long-term maturity assets. Currently you have a Brazilian 2012 yielding about 14% and inflation of around 3%, that’s a pretty high real rate of return. That’s why there remains plenty of opportunities in Latin American fixed income.”
It is not surprising that Aberdeen has 40% of their EMD assets in local currency debt, all of which is hedged. But Bluebay’s David Dowsett adds a note of caution: “In hard currency debt these days, it is much easier to distinguish between one story and the asset class. Local currency markets are at a newer stage of development, they are where hard currency markets were about six years ago in terms of the investor maturity.
“So if South Africa trades poorly then Turkey will trade poorly and it may impact Brazil. Institutional investors who have a long-term commitment to the asset class dominate emerging market hard currency debt. Investors in local markets are more total return orientated, they are in the asset class opportunistically and more likely to be driven by short-term price action. Between May and June 2006 the four-year Turkish Lire bond fell 25%. The four-year bond in dollars was down about 4%!”
Investors of course, have a healthy scepticism over whether the emerging markets have enough political stability for them to be confident that long term bonds will ever be repaid but fund managers see that as a prejudice that gives rise to mispricing of risks and opportunities that they can seize on. Ashmore’s Jerome Booth argues that “the distinction between an emerging market and something which isn’t an emerging market may well be challenged by developed markets going downwards rather than the other way round.
“When a major European country decides to leave the euro and everyone is pricing in 15% inflation in their bonds, then people will question why they think of emerging markets as being high risk while local currency debt has been less volatile than US Treasuries for nearly 10 years!”
It is important to realise that EMD represents several very different types of asset although Ashmore’s Booth would argue that it should still be generically described as a single asset class because “the skill set required to manage it well is quite a well contained and a lot of it is about testing macroeconomic risk and policy risk, getting inside the head of a finance minister. That is the essence of why you would call it an emerging market. In other markets you just assume away sovereign risk.”
The instruments available include investment grade dollar sovereign debt, investment grade sovereign local currency debt, non-investment grade sovereign and local currency debt and corporate dollar debt. In addition, there is a limited amount of local currency corporate debt, which however, is still undeveloped.
Some firms such as Ashmore also invest in distressed debt special situations, which is more akin to private equity requiring very active skills in value creation at the corporate level. Most interest is focussed on sovereign or quasi-sovereign debt of all types, as corporate dollar debt, according to Stone Harbor’s Flanagan, is generally unattractive because “companies accessing the dollar market tend to be better credits than the country and trade at tighter spreads, so you are giving up some liquidity and some spread for essentially the same risk profile, as was seen when Argentina defaulted”.
Analysing sovereign debt requires the ability to make well-judged selection of countries for inclusion. Managers seek to assess economic, political and credit risks on the investible universe of emerging market countries that leads to an assessment of each country’s ability and willingness to service its external debt obligations in a manner that is analogous to analysing corporate debt.
Stone Harbor, for example, sees country selection as the single most important decision in managing emerging markets debt portfolios, accounting for approximately 60% of their value added. The key factors in their evaluation include: the budget balance as percentage of GDP; the current account as a percentage of GDP; the debt as a percentage of GDP; the foreign currency reserves in terms months of imports; the growth in fixed investment; savings as a percentage of GDP; the inflation rate; the unemployment rate; the political stability; interest rates and the direction of future changes. The remaining added value is found through sector and security selection which as well as looking for pricing inefficiencies amongst securities, requires assessing the performance of each sector in different bullish and bearish scenarios.
The addition of liquid and deep local currency debt markets combined with the growth of credit derivatives has opened up a new world of opportunities that any major fixed income fund manager needs to be able to tap. A key issue is whether a manager is offering a beta exposure to the market indices, or is able to offer alpha, often through an absolute return focused product.
Jeff Kaufman of Putnam is sceptical of some approaches: “A pure absolute return fund with no benchmark is a false promise. If you are looking for absolute returns then you have a LIBOR benchmark. You have to explicitly say how it is you are going to achieve absolute returns by taking on beta, generating alpha, or blending the two.
“My problem with the approach which says we are just going to give absolute returns, is it doesn’t tell you where they will be coming from. My suspicion is that many managers have been aggressively long everything, and the returns from beta have been very high for a long time. So prospectively, if there is a downdraft, if beta returns are negative, they are going to get burnt.”
But as he argues: “With yields below 7% on the benchmarks, from a risk adjusted standpoint I think an investor might be better served by trying to look at relative value opportunities within emerging market debt, generally five-10% over LIBOR, double digit returns without the beta exposure. I think that is probably a more attractive product to invest in right now than any type of straight, long-only asset.”
To eliminate the beta exposure requires the ability to go short of credit exposures. But as Kaufman explains: “you can buy credit protection, you can short bonds or you can sell CDX which is a basket of credit default swaps (CDS). Those are all ways of hedging the attractive long positions with shorts that are relatively unattractive.”
Given the wide set of opportunities available, it is not surprising that managers are increasingly offering a number of separate and distinct emerging market debt strategies appealing to different classes of investors. Aberdeen for example, has a traditional hard currency only strategy, another that embraces a wider universe combining hard currency and local currency and a third product that is absolute return driven where the alpha from the team is more important than the beta from the index and used by the Aberdeen fixed income team for internal allocations to EMD for their investment grade portfolios.
EMD as an asset class is gradually overcoming the long-standing prejudices that have led to serious underweightings. Whilst there has been huge inflows of new investment in EMD during the last couple of years, more recently Putnam’s Kaufman finds that “the secular story is still there but a year or two ago there was more of a mandate frenzy coming from the US, Europe and Japan. It’s still coming but is more sporadic now, probably because valuations are less compelling. But we are still seeing steady inflows.”
Stone Harbor’s Paul Timlin sees the first challenge as persuading investors “to think about a broader universe of debt instruments that they are used to. A lot of investors see fixed income as a low risk safety anchor. But in a new world of lower yields, we are seeing a general shift to unconstrained mandates and a widening of opportunity sets. This is being led by the larger and more sophisticated pension plans.” As Ashmore’s Booth points out: “Emerging debt is the great diversifier because if you buy a typical portfolio you have 35 different interest rate / business cycles that really are not correlated to each other. Whereas if I buy US Treasuries I have one interest rate cycle, one business cycle, one political cycle.”
European institutional attitudes to EMD vary tremendously across the continent. Even with the Nordic area, there are specific characteristics that fund managers need to be aware of. Bluebay’s Mattias Hojmark-Jensen finds that “countries like Sweden are not as used to investing in credits as for example Denmark or Finland. Danish pension funds have a long history; of investing in credits having moved into high yield some years ago. They have now trimmed that down and having allocated more money to emerging market debt managers”.
It is a similar story for Finnish pension funds. He says: “Typically the large pension funds in Finland have in-house teams which invest in investment grade and from that it is a natural decision to add external managers for high yield and EMD.
“Sweden in contrast has historically had more of an equity culture,” he points out. “The Swedish have taken risk on equity side and balanced that with domestic fixed income. However, the bigger funds in Sweden have started talking about looking at emerging market debt as they can see that it is important to have in the portfolio.”
In Germany, Ashmore is seeing “a lot of new demand from insurance companies and corporates. The German insurance companies are effectively managing pension pools, so they are long-term institutional investors” according to Booth, whilst in the Netherlands and Scandinavia, Aberdeen, according to Diment, finds that “there has been general interest on alpha focused products in contrast to Switzerland and Italy where the interest is more for traditional long only funds”.
The south of Europe has traditionally been a much more a fixed interest environment than the north, especially in Italy. But as Bluebay’s Roberto Valsecchi Oliva, explains, EMD “has mostly been a market for the retail investor, and for many years Italy has been a huge market for Latin American debt. The pension fund industry is minute in comparison with the Nordic countries, less than 10% the size and is pretty young because it has always been state run. Now diversification is starting to kick in.”
But he goes on to add that “a difficulty these days has been the default in Argentina, and investors are still very cautious following that. Most people will recall what happened to Argentina, which had an enormous impact in Italy, with something like €14bn wiped out from the pockets of savers in Italy.” Many investors he finds “do not have a clear idea of where the market is moving, how emerging markets will evolve”.
As a result, his firm sees its prospective clients as “mainly banks because they are more familiar with risk. They are used to the cycle. Southern European banks, especially Spanish ones, have strong connections with south America, while Italy is also very strong in east European countries. Broadly speaking, pension funds are really only now beginning to look at EMD. Probably in the future you will also start to see the retail side being of interest again!”
EMD is rapidly encompassing so varied a set of strategies across such a wide range of credit ratings that considering it as a single asset class does not do it justice. Both managers and investors are having to grapple with both the increasing size of the marketplace and also the increasing opportunities and complexities.
Those fixed income managers who do not as yet have a capability to invest in dollar denominated debt are rapidly attempting to do so, while it is clear that the rise of local currency debt will mean fund managers not acquiring skills to analyse and invest in these markets are leaving their investors with a much reduced opportunity set for the long term.